Federal Funds are not "Free"

April 12, 2011

In response to the Great Recession, policymakers in Washington, D.C., have chosen massive increases of federal spending, tax rebates and temporary tax cuts as the means to increase aggregate demand. Despite conventional wisdom, federal funds are not "free" and, in fact, contribute a great deal to the unsustainable growth of state government and a resulting decline in economic growth, say economists Donna Arduin, Arthur B. Laffer and Wayne Winegarden.

These spending policies have not produced the desired results, with economic weakness returning in the second quarter of 2010 and likely continuing well into the future. The reason: economic prescriptions focused on increasing aggregate demand wrongly take into account the impact that government spending has on the economy.

Increases in federal, state or local government spending change the underlying incentives in the economy and reduce its growth potential, which is why the current trend of increased reliance of states on federal funds is problematic.

Due to the excessive level of federal expenditures, control of expenditures at the state and local levels is more crucial than ever.

However, the American Recovery and Reinvestment Act funds co-opted states into keeping state spending at levels that they -- more precisely, their citizens -- cannot afford.

This reliance on the federal government to keep state spending high worsens two troubling trends.

First, greater reliance on federal funds by states also means greater control of state programs by federal authorities.

This leads to the second troubling trend created by the increased dependence on federal funds -- the higher bias toward greater spending.

Indeed, not only does relying on larger federal contributions to state programs lead to shorter higher spending, but the federal spending mandates that often come with them result in greater federal control on state and local governments that increase spending in the long term. Greater federal spending mandates put upward pressure on total state spending levels, say Arduin, Laffer and Winegarden.